Researching For Deductions

I was skimming a Tax Court case that almost made me laugh out loud.

It initially caught my attention because it involved a deduction for research costs.

The tax surrounding research costs come in two flavors:

·      What is deductible as research?

·      And – perhaps more importantly – can you get a tax credit for it?

Let’s talk this time about the first question, which may not be what you anticipate. Here is an example:

You build a garage to store your business equipment. The garage’s claim to fame is that it is built from natural fibers rather than bricks and lumber. It is the Kon-Tiki of garages. Can you deduct the cost of the garage as you build it?

At the end of the day, you will have a building. Granted, it may be unusual, but it is still a building. Can you deduct a building as you go along? Or do you have to accumulate (and defer) the cost until the building is ready for use? And then what - do you deduct the accumulated cost at that time or do you deduct the cost over a period of years?

You will be deducting the cost over a period of years, otherwise known as depreciation. You self-constructed a long-lived asset, and the tax Code (barring the unusual) will not let you deduct it immediately.

Let’s swing back to research costs.

What if the research costs result in a patent?

You have legal rights for a period of years to intellectual property, and the patent may be worth a fortune.

So we rephrase the question: can you immediately deduct the research costs resulting in that patent?

But CTG, you say, the two are not the same. Chances are that salaries make-up most of the research costs. It doesn’t seem right to capitalize and depreciate salaries. Sticks and bricks have staying power; they last for years. It makes more sense to depreciate those rather than salaries.

Hmmm. What about the wages of the tradesmen-and-women that constructed the building? Do we get to carve those out from the sticks-and-bricks and deduct them immediately?

Of course not.

You now get the issue with research costs.

To answer it the tax Code gives us Section 174:

        (a)  Treatment as expenses.

(1)  In general.

A taxpayer may treat research or experimental expenditures which are paid or incurred by him during the taxable year in connection with his trade or business as expenses which are not chargeable to capital account. The expenditures so treated shall be allowed as a deduction.

As long as the costs meet the definition of “research or experimental expenditures,” you have the option of deducting them immediately.

Problem solved.

Our case this time is Bradley and Hayes-Hunter v Commissioner.

Mr. Bradley was a litigation consultant. He reviewed evidence, provided expert testimony and conducted legal research. He was self-employed, and on his 2014 individual income tax return he deducted $25,000 as “Research.”

The IRS was curious what “research and experimental expenditures” a litigation coach could possibly have. It is well-trod ground that Section 174 addresses research in an “experimental” or “laboratory” sense. While one does not have to be in a Pfizer lab wearing a white coat, one likewise cannot be in a library shepardizing law cases.

What did he deduct?

I will give you a clue: his billing rate was $250 per hour.

He deducted $25,000.

And $25,000 divided by $250 is 100 hours.

Not only was he nowhere near a Section 174 research cost, he was also deducting his own time.

How I wish.

Who knows how much tax research I do over an average year. If I could only deduct my time, I would never pay income taxes again.

It won’t work for me, and it did not work for Mr. Bradley.